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Understanding Cash-out Refinancing

Explore the Current Market & Your Options to Leverage Your Home Equity

When you are considering a cash-out refinancing, you will likely be comparing your pros and cons and evaluating deals much more minutely than with most other loan products. A cash-out refinancing product suggests that you are not a novice in your borrowing – by definition, you have to already have an existing mortgage to even be considering one.

You've paid some dues now, and want to make a smart move for your future…so is a cash-out refinancing option the best way to get the money you need?

This article will tackle all you need to know about cash-out refinancing, from its definition through its best-case scenarios. There is a lot to learn, but proper study and understanding can help you make a better decision with your long-term financing. For starters, here are current cash out refi rates available today in your local area.

The Real Estate Market as a Whole

According to Zillow, the US real estate market grew in 2018 to be worth almost $32 trillion in residential properties. By the end of Q1 2018, the number of mortgages on these properties was clocking-in with a value at $14.9 trillion, based on the Federal Reserve’s quarterly statistics.

Black Knight, a company offering reports, insights and data on the US real estate market, states that homeowners here now have about $5.4 trillion in earned equity, collectively. This is a number that is also growing recently as property values increase rapidly all across the nation.

The 2012-2016 American Community Survey 5-Year Estimate offers the following housing statistics.

Type of Dwelling / Financing Status

Unit Quantity

Marketshare

total residential units

134,054,899

100.00%

occupied by renter or owner

117,716,237

87.81%

occupied by renter

42,853,169

31.95%

occupied by owner

74,881,068

55.86%

— no mortgage

26,864,528

20.04%

— mortgaged

48,016,540

35.82%

—— no second mortgage, no home equity loan

40,296,854

30.06%

—— second mortgage AND home equity loan

281,865

0.21%

—— second mortgage OR home equity loan

7,437,821

5.55%

——— only home equity loan

5,715,049

4.26%

——— only second mortgage

1,722,772

1.29%

Factors that will directly affect the real estate market, and the amount of equity it holds include:

Interest rates on loans – interest rates in 2018 are still low but slowly rising, coming up steadily from the record lows hit in the housing boom of 2008

Property values – property values across the nation are rising, especially in key metropolitan areas that account for about 36% of the total value of US real estate holdings. Typically during economic booms key urban markets appreciate faster than rural markets.

Your payment history - if you have paid on a loan for many years or have made extra payments then you will build more equity than someone who only makes minimum payments and recently purchased a similar home in the same area.

CoreLogic reported that in 2017, homeowners gained about $15,000 in equity on average across the US. This number is much higher in some metro areas, such as Seattle or California, where it could be as much as $40,000 gained in the same time period.

As the amount of equity builds for homeowners, many are looking to lending products designed to harness this growth, such as Home Equity Lines of Credit (HELOCs) and cash-out refinancing.

What Is Cash-Out Refinancing?

As the name implies, a cash-out refinancing means you are refinancing your remaining mortgage balance, and then taking additional “cash out” of your earned equity to arrive at a new mortgage balance. Taken at its most basic tenets, it is a mortgage refinancing along with a lump sum payout.

Typically used to cover a large expense like education, health care, a second home’s down payment or something similar, you will refinance your current mortgage balance while also getting some more cash in a lump sum to use at your discretion, now.

The obvious difference between a cash-out refinancing and a typical refi-mortgage, is the additional lump sum to be used at the borrower’s discretion. A refi would allow you to cover only the mortgage costs and balances.

For example, you may have a home appraised at $200,000 on which you still owe $50,000 – and you need $30,000 for a specific cost, now.

You are typically allowed to borrow about 80% of your earned equity. Retaining 20% equity in your property ($40,000) means you could likely borrow up to $110,000 from your earned equity ($150,000- 40,000) with a cash-out refinancing.

You are seeking only $80,000 to cover the remaining mortgage and your specific costs, so this could make a cash-out refinancing plan a reasonable option for you to consider.

Like a typical mortgage, you will have to remember to figure-in closing costs and pay monthly installments for the duration of the loan – typically, 15 or 30 years. And note as well – your mortgage balance would now be $80,000 instead of the $50K you owed, so you've reset the mortgage clock and its balance, too.

Description

Amount

Home Value

Current Balance

Loan to Value

Cash Out Limit

70%

75%

80%

85%

90%

95%

100%

When Does it Make Sense to Cash Out Refinance?

As with any lending vehicle, you are going to be seeking the best possible rates and terms. If you have a low interest rate on your existing mortgage, it would not make sense to refinance at a higher rate. But you can often find a cash-out refinance loan with a lower interest rate than your current mortgage.

A cash-out refinancing makes sense when the amount of money you want is relatively high compared to your mortgage balance. If you need less money, it may make sense to find a different lending product that allows you to pay it off faster, accruing less interest over time. A cash out refi can take a month to 6 weeks to close and will likely include thousands of dollars in loan origination & processing fees.

When you are using the lump sum to improve on your home, there are tax benefits. These benefits will be truncated or lost when the money is applied to other uses. If you withdraw equity for home improvement the mortgage debt is considered origination debt, but you need to keep your receipts in case you are questioned on the deduction.

You need to ensure that making payments is not going to present a hurdle for you over time. You are using your home as collateral, so missed payments could result in a foreclosure and property loss. Your debt-to-income (DTI) level is also measured by lenders to determine your creditworthiness for this financing, so a larger payment must be reasonable for you to qualify.

What About Taxes?

Though you receive a lump sum payment, a cash-out refinance is not seen as additional income for taxable purposes. The lump sum is financed in the loan costs, so you will not have that additionally taxed as personal income.

The 2017 Tax Cuts and Jobs Act lowered the cap on tax-deductible mortgage debt from the interest on $1 million in mortgage debt to $750,000 in mortgage debt. Homes which had a mortgage in place before the new bill passed were grandfathered in and retained the old limit. When a house is refinanced to replace a previously existing loan the refi is grandfathered in as well, however it is only grandfathered in to the balance which was on the loan prior to refinancing. If you add further debt via a cash out, those interest payments will only be considered tax deductible if the money was used to build or substantially improve the value of the home.

Second mortgages are also treated similarly in terms of being able to deduct interest payments from income taxes if the debt is used to improve the home. There are limits, which are currently $100,000 or $50,000 if married and filing separately. Be sure to speak with your CPA or a qualified tax professional for proper tax guidance and advice.

Some people use the proceeds from a cash-out refinancing to consolidate high-interest credit card debt & pay off other debts. Credit card debt is unsecured, while mortgage debt is secured by the property. If the credit card debt was obtained through a now-resolved medical issue then perhaps it can make sense to consolidate it, but if it was obtained through wasteful discretionary spending it is usually not advised to convert unsecured debt into secured debt because in many cases the unsecured debt will quickly build up again while the debt against the property increases the risk of eventual foreclosure.

Common Uses for Cash-Out Refinance

Renovations and improvements: in addition to the tax benefits mentioned earlier, performing renovations and property improvements will help to build additional equity and long-term value in your home. The higher cost of renovations also often makes it a better move for this type of longer-term, fixed-rate financing.

Debt consolidation: whether it is consolidating credit cards or combining a variety of different types of debt, you can often reduce your number of payments – which will affect your DTI in a positive way. There are advantages to lowering interest expenses & wrapping your debt into a single payment – just remember that it is all secured by your home, so failure to pay will mean foreclosure.

Education: whether it be for yourself or a family member, a higher education is very expensive, even at the community level. A cash-out refinance can cover the tuition costs and more, allowing you to position yourself or someone you love in a better position to earn. It can help you rely less on other financing methods to cover the related fees and expenses. It is projected nearly 40% of students with student debt will go into default by 2023. Student debt generally cannot be discharged through bankruptcy & when student debt is forgiven the entire amount is typically counted as income in the year the debt is forgiven, which means one owes income taxes on a lot of income they never received.

Additional properties: a second home, or even a rental property is often the way funds from a cash-out refinance are directed. Using the money to cover a down payment and closing costs can help a homeowner grow their real estate portfolio, spreading the cost over time at a lower interest rate.

Cash reserves: a popular option with small business owners, tapping your home’s equity when the market conditions are good could allow you to put away a “rainy day fund” to help you weather any future tough times or unplanned emergencies.

While these are only some of the uses, keep in mind that you can use the funds for anything you decide. You should approach it with caution however, as tapping into your home’s equity this way for cash is not always going to be your best bet for financing.

Comparing Popular Options

As mentioned at the start of this article, when you are considering a cash-out refinancing, you are definitely going to be weighing it against other options your local lenders can offer you. You may also be looking at federally sponsored programs such as VA and FHA loans.

Some of the main criteria in comparisons should be fees and interest rates, tax advantages, monthly payments, terms (years to pay) and intended use of the money.

We will look at four of the more common options for harvesting equity and refinancing – and when each option may make a smart move for you.

This table shows that most share the qualities of traditional financing, but a HELOC offers more flexibility:

Feature

Cash out refinance

Home equity loan

HELOC

Personal loan

Adjustable interest rate

X

X (can be fixed rate)

Fixed interest rate

X

X

X (can be variable)

Interest-only payment option

X

Pay on ONLY what you use

X

15 or 30-year terms

X

X

X

Good for smaller purchases

X

X

X

Interest rates offered, best to worst, would likely be home equity loan, cash-out refinance, personal loan then the HELOC. Fees are likely to be highest with a cash-out refinance, as are your qualification hurdles.

Deciding between the different types of loans is usually going to be largely dependent on your intended use for the funds. How much you need, and for what purpose can direct you toward one loan over another.

Cash Out Refi

When interest rates are low or falling many homeowners have incentive to refinance their home to save on their interest expenses. Refinancing a home can cost thousands of dollars in loan origination and processing fees, but those can easily be paid for by even small reductions in interest rates.

As the Federal Reserve has lifted interest rates over the past couple years the structure of the mortgage market has changed dramatically in a shift away from refinances to home purchases. Nearly 70% of mortgages are now for home purchases, whereas a few years ago refinances dominated the market.

Home Equity Lines of Credit

The HELOC acts more like a credit card, so it has a draw period (5-10 years where you can purchase things) and a repayment period (usually 10 to 20 years). The rate with a HELOC will most often be variable, making it a bit riskier than the other options in this regard. It is also common to overdraw a bit with a HELOC and incur harder-to-handle payments of interest-and-principal.

However, the HELOC can be a smart move when you have a series of smaller costs, perhaps spread out over a short time, and want to handle them fluidly. The ability to pay interest-only, and only on the amount you draw makes this option attractive for many borrowers.

HELOCs and home equity loans are typically approved in a 2 to 4 week period, with the approval process rarely taking more than 6 weeks.

HELOCs are very popular with consumers, and lenders have created a variety of hybrid products that help expand the possibilities for affordable borrowing. Some offer fixed rates or a combination of variable and fixed. As this segment of the market grows you can expect more banks to offer additional lending products to cater to the consumer demand.

In 2017 TransUnion published a study on the return of HELOCs which stated they anticipate there will be approximately 10 million HELOCs originated between 2018 and 2022.

Year

HELOC Originations

2012

700,000

2013

800,000

2014

1,000,000

2015

1,100,000

2016

1,200,000

2017

1,400,000

2018

1,600,000

avg/yr 19-22

2,100,000

2019-2022 total

8,400,000

Homeowners use HELOCs for many of the same reasons they refinance first mortgages.

Category

Percent

Description

Debt Consolidation

30%

Consolidate credit card debt & other higher interest forms of credit

Large Expense

29%

Paying for a large home renovation or other similar credit need

Refinance

25%

Replacing a prior HELOC with a better rate or other advantageous change of terms

Piggyback

9%

Used as part of a down-payment on a mortgage origination

Undrawn

7%

Line of credit on standby for a rainy day.

Home Equity Loans

Home equity loans, like a cash-out refinance, will use the home as collateral for the loan’s repayment. The main difference between them otherwise, is the addition of the existing mortgage, for a home equity loan does not include coverage of your mortgage refi, as with a cash-out refinance.

Instead, a home equity loan uses some of your earned equity to get you capital, now. It is often called a second mortgage and provides you a lump sum payout, to be used at your discretion. It will usually have an interest rate similar to a cash-out refi. While these loans are not as common or popular as a HELOC, many lenders will offer them.

Personal Loans

Personal loans are typically shorter-term loans, and larger amounts could require some form of securing collateral, though non-collateralized (unsecured) personal loans are common. The interest rate will be a few points higher than a mortgage to cover the lender’s risk, but your improving personal credit score and a lower DTI ratio will help you qualify for better offers.

Personal loans can be smart options when a smaller amount is needed, or the future is less certain than the present. You may pay slightly more in interest rates but will generally complete the loan in far less time, so will pay less overall for what is borrowed.

Note that personal loans may be offered from independent lenders, and not just banks. Be sure to compare rates and fees, as they will vary widely by provider. Numerous online platforms like LendingClub and Prosper also offer these types of loans.

Credit Cards

Credit card debt which rolls over for an extended period of time can be exceptionally expensive. For that reason it is not advisable to carry a large credit card balance, but if you can find a card with a low introductory rate or a zero interest introductory period then it can make sense to leverage that so long as you can pay the card off before the higher rates of interest kick in. Some people are experts in stacking rewards programs which make the cards effectively less than free when the rewards programs are coupled with a low interest rate.

Alternative Finance & Fractional Home Ownership Programs

Some fintech startups offer equity sharing services which allow homeowners to sell a fractional stake in their homes, while other platforms will pay off the home and then lease it back to the homeowner. There are 3 big issues with these sorts off offerings.

The United States residential real estate market is heavily subsidized by the federal government through the use of tax breaks and through the use of government sponsored entities (GSEs) in Fannie Mae & Freddie Mac which provide liquidity in the secondary markets and hold down rates.
During the Great Recession further subsidies were provided through bailouts and a quantitative easing program which saw the Federal Reserve purchase both treasuries and mortgage-backed securities.

After the subprime mortgage led great recession, the traditional home financing market has significant competition, transparency, & many consumer protections baked in via the Dodd-Frank law & the Consumer Protection Finance Bureau.

Many fast-growing startups have a risk of flaming out when market conditions turn. Fintech companies like Figure, Point, Unison or EasyKnock may have the best of intentions, but they can't control the economic cycle & are not as systematically important to the economic system as the GSEs or the big banks which were bailed out. Beepi was a fast-growing used car marketplace which raised over a hundred million of dollars, grew quickly, flamed out & was sold for parts.

It is probably advisable to see how the alternative finance companies perform throughout an economic cycle before considering them. Buying a home is something which should add stability to your family life & is not a great area to try something new on such a large purchase, particularly when the core market is so cost effective.

The last time I ran numbers on one of these schemes, the parameters provided were to assume 4% appreciation, combined PMI/rate savings from having more down would be 0.5%, $1m home, 5 year ownership horizon, and the equity investor would reap 30% of appreciation. Those were the assumptions the homebuyer gave me.
It amounted to paying $65k to "save" $15k. Sounds like a great deal for the equity investor.
Here it is. Saving $259/mo times 60 months was $15,540.
At 4% appreciation, the $1m home would be worth $1.216m after 5 years. 30% of $216k is $64,800.
Turns out there is something worse than PMI.
If you stretch it out more than 5 years, or assume more than 4% appreciation, the gap will simply get larger.

Seniors who want to use their home's equity to finance a retirement may want to consider a reverse mortgage, but it probably makes sense to see how the alternative equity providers do through a full economic cycle before considering them as a viable alternative to a vanilla mortgage.

Choosing Wisely

With all forms of financing, it is incumbent on the borrower to understand the details, ramifications and requirements of their loan product. A cash-out refinance should inspire perhaps the most research and comparison, as these loans can be among the most complicated of mortgages.

However, as outlined above, in the right circumstances a cash-out refinancing can offer you the liquidity to accomplish many positive steps forward. You will want to carefully weigh each option against the others to determine which loan product truly makes your best fit – both now, and over time.

You generally want a specific purpose for the funds – or a HELOC might be more applicable, to have the credit line open as need be. Compare, at a minimum, the differences in:

Fees

Interest rates/APR

Terms (duration)

Qualification time/processing time

Tax implications

Monthly payments

By understanding clearly how a cash-out refinance works, you can add it to your arsenal of potential solutions and take advantage of your earned equity. By understanding how a cash-out refinance compares to your other options, you will be able to make the best selection for your situation, both now and in the future.